Behavioural biases — such as overconfidence or reacting impulsively to market fluctuations — are one of the most significant challenges investors face, experts say.
Oxford Risk, a behavioural finance fintech, estimates emotional responses can reduce investment returns by up to 3 per cent a year. Other studies by Vanguard, Russell Investments show similar figures.
Behavioural biases, systematic patterns of thinking and decision-making, can cloud judgement, leading to costly mistakes. The growing field of behavioural finance studies how these biases impact our financial decisions, helping investors become aware of their tendencies and develop strategies to mitigate them.
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Experts tell Spear’s how investors can stay focused on their long-term objectives and avoid the pitfalls of emotional decision-making.
Eight common behavioural biases
Managing emotions, focusing on a sound decision-making process, and avoiding common psychological traps are essential steps to building long-term wealth.
Joe Wiggins, a behavioural finance expert and Investment Research Director at St. James’s Place, has identified eight common behavioural biases investors frequently encounter,
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‘Investing is a difficult decision-making process because we are constantly bombarded with news, noise, and temptations to make poor choices,’ he says.
‘Even with a well-aligned portfolio, if we don’t control our behaviour, we are unlikely to meet our objectives. It’s essential to understand the behavioural challenges we face and plan for them, not just our asset allocation,’ Wiggins explains.
Alexander Joshi, Head of Behavioural Finance at Barclays Private Bank tells Spear’s: ‘Being aware of your behavioural biases and knowing how to overcome them can help you make better investment decisions and improve your chances of success. Working with investment experts is one way investors can get a handle on the biases and emotions that are likely to influence their behaviour.’
How to avoid these eight most costly behavioural biases when investing.
1. Loss aversion: The pain of losing feels worse than the joy of winning
Loss aversion is the tendency to feel losses more strongly than equivalent gains. Studies by Daniel Kahneman and Amos Tversky suggest people feel losses twice as intensely as gains. In investing, this can lead to overly cautious behaviour, such as selling investments during market downturns, missing out on potential long-term gains, or holding onto losing investments in the hope they’ll recover.
Tip: Check your portfolio less frequently to avoid reacting emotionally to short-term losses. Focusing on the long-term is essential for benefiting from equity market gains.
Wiggins says: ‘A key skill is to detach ourselves from short-term market noise and focus on the bigger picture.’
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2. Outcome bias: Judging decisions by results, not process
Outcome bias is the inclination to evaluate decisions based on their outcomes rather than the soundness of the decision-making process. Investors may think that past performance guarantees future success, or that poor performance means a bad decision was made, ignoring that external factors can skew results.
Tip: Focus on a diversified, sound investment process rather than getting caught up in recent performance. Past success may often be a result of luck rather than skill.
Wiggins says: ‘Outcome bias leads us to misinterpret past performance as a sign of skill rather than luck…Diversify and focus on a sound investment process, not just recent outcomes.’
3. Emotions in investing: The unseen influence
Many investors believe they’re rational, but emotions like fear and excitement often guide their decisions during times of financial stress or market volatility. These emotions can lead to impulsive decisions that go against long-term goals.
Tip: Recognise when emotions are influencing your decisions, and systematise your investment approach to minimise their impact.
‘We love to think of ourselves as cool, rational decision-making machines, but actually, when we make decisions, it’s so often about how we feel in the moment — fear, greed, excitement — rather than a rational analysis,’ Wiggins explains.
4. Overconfidence: A common trap for investors
Overconfidence is a dangerous trait in investing. It can lead people to believe they’re better than average, resulting in riskier decisions. Many think they can beat the market or avoid pitfalls that affect others.
Tip: Acknowledge that you may not have superior market insight. Avoid assuming you’re always in the ‘winning’ minority, and diversify your investments to mitigate risk.
‘It seems to be innate in humans that we think we’re better than other people and we’re better than the average. So, when we see the advert for the betting company and it says 90% of our clients lose money, we think we’re in the 10% almost inevitably,’ says Wiggins.
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5. The power of stories and their impact on investments
Humans are drawn to compelling stories, and this can cloud judgement when making investment decisions. Engaging narratives about certain sectors or trends can drive investment enthusiasm, even when they lack strong evidence.
Tip: Be cautious of stories that seem too good to be true, and focus on factual analysis. Always verify the substance behind any narrative.
‘Adults love stories, and particularly in investing, stories are part of the human condition,’ says Wiggins. ‘They make complex, chaotic worlds clearer and easier to explain, even if those explanations are somewhat erroneous.’
6. Action bias: The urge to act against better judgement
Action bias is the instinct to make changes to your portfolio even when inaction would be the smarter choice. Market volatility can lead investors to frequently adjust their holdings, which often results in higher costs and suboptimal decisions.
Tip: Embrace inaction as your default strategy. Financial markets are unpredictable, so maintaining a consistent, long-term approach is generally more effective than reacting to every fluctuation.
Wiggins, explains: ‘Because financial markets are volatile and chaotic and unpredictable, we feel like we need to change our portfolio.
‘That’s exactly the wrong route to take. We should be saying we cannot predict these things. We just have to accept it as a feature of financial markets and therefore being stable, being consistent is much more important.’
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7. The perils of predictions: Avoiding the forecasting trap
Investors are naturally inclined to predict future market trends, despite the overwhelming evidence that such predictions are often unreliable. Basing an investment strategy on predictions can lead to misguided decisions and lower returns.
Tip: Stay diversified and avoid relying on short-term market forecasts. Focus on building a portfolio aligned with your long-term goals rather than trying to time the market.
‘The more confident we are of the future, the less diversified we are, so by remaining diversified in a way that’s appropriate for our own long-run objectives, that’s the best protection against making those types of predictions sensibly diversified,’ notes Wiggins.
Joshi says the ‘availability heuristic is a ‘mental rule of thumb which leads to more emotive or dramatic headlines taking up more importance in our minds, which can lead investors to overstate the importance of particular events on their investment portfolios’.
‘It’s important to remember that headlines don’t necessarily translate to market moves, and market moves don’t necessarily translate into portfolio moves, in particular for investors that are holding well-diversified portfolios.’
8. Understanding narratives in investing
In the financial world, narratives are simplified stories that make complex events easier to understand. However, while these stories can help make sense of market movements, they often lead to biases when investors rely too heavily on them instead of sound analysis.
Tip: Be mindful of the influence of narratives. Make decisions based on objective data, long-term goals, and diversification, rather than getting swept up in the latest trends.
Wiggins says: ‘Setting expectations correctly at the start and knowing that you’ll have to deal with those behavioural challenges, that it’s part of generating good long-term returns, will be helpful to you.’
Joshi says mental accounting can leads investors to treat money differently depending on factors such as its origin and intended use.
‘For example, money intended for a child’s education or retirement. This can be useful for budgeting and wealth planning, but it can also lead to a suboptimal use of funds, particularly if too much is held in cash. Money is fungible, but in mental accounting, people treat it as less fungible than it really is. Keeping a holistic view of one’s entire wealth to ensure it is being used as productively as possible can help overcome this.’
